Friday, May 20, 2016

The real cost of buying a new car

I am a fairly frugal person. An example of that is the fact that I drive a 15 year old car. I would likely keep driving this car until all is left is the steering wheel. The money I have saved always purchasing second hand cars would result in me being richer by hundreds of thousands of dollars over my lifetime. I do not see the point of buying an expensive new car every five years in order to get from point A to point B, when an older but reliable car can do the same thing for less.

Not everyone is like me of course, and I am totally fine with this. I sometimes realize however why some individuals would never accumulate a lot of money for their retirement. As someone in the accumulation phase, I have come to realize that the only inputs I have control over include:

1) The amount I can save and invest
2) The type of investments I choose to put my savings in
3) Maintaining low transaction and tax costs associated with investments
4) Sticking to my strategy even if someone is (temporarily) getting rich faster than me

There was a young fellow at my previous work, who had recently graduated from school. He received as a graduation present, an expensive German car worth something like $70,000. This person does not save money, but has decided that he deserves a shiny new car. In addition, he doesn't even invest in the company 401 (k) plan, because he doesn't trust the stock market. He is afraid to lose money in the markets. If I were in his shoes at the time I graduated, I would have taken the $70,000 in cash and invested it, rather than buy a shiny new and expensive toy. The opportunity cost of those $70,000 for someone in their 20s is huge. His base salary was $48,000/year. So you could say that he spent an amount equivalent to an year and a half of after-tax salary income for a new car.

I see several issues with his kind of thinking. The first issue is that with stocks, there is a high likelihood that if you hold a diversified portfolio, you are almost guaranteed to come out ahead after 20 - 25 years. In contrast, a car is destined to lose its value over time. If I were in this fellow’s shoes, I would have likely requested that the parents provide the $70,000 in cash or in the very least give them as a down payment on a house or apartment.

The second issue I see with this thinking is that this person is afraid of investing in companies, despite the fact that he was the top student in his business class. He knows US GAAP, understands business and finance, and is fluent in four languages. He works hard at his job, and is destined for a top management position within an organization within a decade. However, he does not know how to put this book knowledge to work in the real world. He is afraid to take a risk and earn a return, while taking a guaranteed loss on the purchase of the car. I think the lesson from this issue is that knowledge is important, but without using this knowledge correctly, you are wasting your talents.

The largest issue I see is that this young professional is missing out on the power of compounding. This is particularly shameful, given the fact that he likely has approximately four decades before he is eligible for Social Security. If he invested that $70,000 in a portfolio of dividend growth stocks yielding 3% today, he would be earning close to $2,100 in annual dividend income. Let's assume that these companies grew dividends at a rate of 4%/year. This is a very conservative estimate, since historical dividend growth has been somewhere around 5% - 5.50%/year. If this young person managed to reinvest those growing dividends into more companies yielding 3% and growing dividends by 4%/year, he would be generating a nice $4,200 in annual dividend income in a decade. In addition, the value of those shares would likely be higher than the value of the car. And they would not cost much in terms of regular maintenance.

Even he put his money in low cost index funds (since he doesn’t know anything about investing), and earned 10% per year in total returns, he would end up with $758 thousand dollars in 25 years. If he could earn a 3% dividend yield on his portfolio, this would translate into almost $23,000 in annual dividend income. In forty years, he would have approximately $3.168 million dollars to his name, just from that $70 thousand seed amount. At a 3% dividend yield, this could translate to over $90,000 in annual dividend income. When you have a long period of time, and you can earn a decent rate of return, the power of compounding can turn large amounts of money into an even larger amount of money. I realize that the stock market do not and might not deliver a straight 10% total return every year, but historically, since 1926 stocks have managed to do that. Index funds also do not yield 3%, although constructing a portfolio of dividend paying stocks could do the trick.

The whole reason I am writing this article, is to share a lesson with the audience. It is important to learn from mistakes of others, in order for you to avoid making them. There is nothing wrong with buying a reliable car to take you from point A to point B. You do not have to live a miserly life, and make your own shampoo or toothpaste. A balance between spending and saving is important. But spending an amount that is equivalent to years worth of after-tax income on a car that will lose a large portion of its value in a few years is not a smart way to build your net worth.

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